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  • Jennifer M Mueller-Phillips
    Internal Controls and Conditional Conservatism
    research summary posted October 24, 2013 by Jennifer M Mueller-Phillips, tagged 07.0 Internal Control, 07.03 Reporting Material Weaknesses, 07.05 Impact of 404 on Fees and Financial Reporting Quality in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Internal Controls and Conditional Conservatism
    Practical Implications:

    This study provides insights to regulators given potentially conflicting perspectives as to the benefits of financial reporting conservatism. Regulators view conservatism as allowing the deliberate understatement of assets or income and/or the deliberate overstatement of liabilities or expenses, rendering financial statements not neutral and, therefore, jeopardizing the quality of reliability and unbiasedness desired by the conceptual framework. In contrast, the benefits of conservatism lie in the agency conflict conservatism whereby it reduces managers’ ability and incentives to overstate earnings and net assets by requiring higher verification standards for gain recognition and reduces managers’ ability to withhold information on expected losses. As the results suggest that strong internal controls facilitate conservatism, this may increase concern among regulators opposed to accounting conservatism.

    For more information on this study, please contact Beng Wee Goh.
     

    Citation:

    Goh, B. W. and D. Li. 2011. Internal Controls and Conditional Conservatism.  The Accounting Review 86 (3):  975-1005. 

    Keywords:
    internal controls; conservatism; material weaknesses; Sarbanes-Oxley Act.
    Purpose of the Study:

    In 2002, the U.S. Congress passed the Sarbanes-Oxley Act (SOX) to improve the quality of financial reporting and to restore investor confidence in the reliability of financial statements. An important aspect of SOX is its internal control reporting requirements, which allow investors to be informed about the quality of a firm’s internal controls. Given the importance of the internal control provisions as a means to improve the governance of firms, this study extends the literature on the reporting effects of strong versus weak internal controls by examining how the quality of internal controls is related to conservatism in financial reporting. Specifically, the authors examine whether material weakness (MW) firms that subsequently remediate their weaknesses exhibit different levels of conservatism from MW firms that continue to have these weaknesses. The authors define conservatism as the higher degree of verification to recognize good news as gains than to recognize bad news as losses and place emphasis here because it has been argued to provide several governance benefits, such as reducing agency conflicts and improving managerial investment decisions, enhancing the efficiency of debt contracts, and reducing litigation costs.

    Design/Method/ Approach:

    The authors identify 1,098 firms that, under either SOX 302 or SOX 404, disclose at least one MW from January 2003 to November 2005 and focus on firms that disclosed MWs because the reporting of MWs is mandatory, whereas the reporting of significant deficiencies and control deficiencies is not. The authors examine the fiscal years 2000 and 2001 to test whether there is a relationship between internal control quality and conservatism because these years just precede the enactment of SOX and, hence, avoid any confounding effects due to SOX. Therefore, the authors rely on the assumption that MWs exist within the firm even before their disclosures from January 2003 to November 2005. The authors utilize three measures of conservatism that are commonly used in the literature to capture the asymmetric timeliness in the recognition of economic losses: (1) persistence of earnings changes, (2) accrual-based loss recognition, and (3) the timeliness of earnings to news. In their second analysis the authors focus solely on the MW sample of firms because remediation is required in their test of whether remediating firms exhibit a difference in conservatism when compared to those that fail to remediate.

    Findings:
    • The results using all three measures of conservatism noted above are consistent with a positive relation between internal control quality and conservatism. Specifically, the authors find that MW firms exhibit lower conservatism than control firms without such weaknesses. Results using all three measures of conservatism are consistent with a positive relation between internal control quality and conservatism.
    • Furthermore, the authors show that MW firms that subsequently remediate their weaknesses (i.e., show an improvement in internal control quality) exhibit greater conservatism than MW firms that continue to have these weaknesses.

    Therefore, the authors’ results are consistent with strong internal controls serving as a mechanism that facilitates conservatism.

    Category:
    Internal Control
    Sub-category:
    Impact of 404 on Fees and Financial Reporting Quality, Reporting Material Weaknesses
  • Jennifer M Mueller-Phillips
    Material Weakness Remediation and Earnings Quality: A...
    research summary posted October 16, 2015 by Jennifer M Mueller-Phillips, tagged 07.0 Internal Control, 07.02 Assessing Material Weaknesses, 07.03 Reporting Material Weaknesses, 07.04 Assessing Remediation of Weaknesses, 07.05 Impact of 404 on Fees and Financial Reporting Quality in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Material Weakness Remediation and Earnings Quality: A Detailed Examination by Type of Control Deficiency.
    Practical Implications:

    Combining the remediation and earnings quality analyses, the results imply that investors should be most concerned about MWs in information technology, segregation of duties, account reconciliations, taxation, revenues, and inventory. These types occur frequently and are slow to remediate; thus, their effects on financial reporting linger longer than others. Their link to near-term earnings quality is evident, as their remediation reduces abnormal accruals, and/or their lack of remediation in the following year further increases accruals. In general, these results suggest that financial statement users should adopt a more granular view of remediation, as successful remediation of some specific MWs can signal improvement in the quality of disclosed financial information even if other MWs remain unremediated.

    Citation:

    Bedard, J. C., R. Hoitash, U. Hoitash, and K. Westermann. 2012. Material Weakness Remediation and Earnings Quality: A Detailed Examination by Type of Control Deficiency. Auditing: A Journal of Practice & Theory 31 (1): 57-78.

    Keywords:
    internal control, material weakness, remediation, Sarbanes-Oxley Section 404
    Purpose of the Study:

    This paper investigates the remediation likelihood of specific types of Sarbanes-Oxley (SOX) Section 404 material weaknesses (MWs) in internal control over financial reporting, and the association between remediation of specific types of MW with changes in earnings quality. This detailed look at remediation is important because companies disclose many types of control problems under Section 404, which likely vary in remediation difficulty as well as in impact on the financial reports. Because the goal of Section 404 is to improve financial reporting, it is important to identify specific areas in which control problems are less tractable and more influential. However, no study yet provides a detailed, comprehensive analysis of remediation by specific MW type. The authors first examine remediation rates by specific MW type, and investigate the association of MW type remediation with constraints identified by prior research. Next, they investigate which MW types have greater influence on earnings quality, by associating remediation of specific types with reductions in abnormal accruals. 

    Design/Method/ Approach:

    The authors obtain data on Section 404 MW from 20042006 from the AA database. They gather auditor information from AA, financial data from Compustat, and institutional ownership from Thomson Financial. The authors’ final sample consists of 567 observations that reported Section 404 MWs in either 2004 or 2005, representing 496 companies.

    Findings:
    • Finer classification does provide greater insight in showing that all specific entity-level MW types exhibit lower remediation likelihood.
    • Companies with fewer resources are less likely to remediate problems that involve large capital investments.
    • Companies with weaker governance are less likely to remediate problems linked by past research to earnings management.
    • Most companies with repeated disclosure of ineffective controls engaged in some successful remediation activity following initial disclosure, as only 3 percent had no success in remediating any MW types.
    • Certain types of MW have a greater impact on earnings quality, both when disclosed and when remediated, including some entity-level and some account-specific MW types. For most of these types, remediation reverses the higher abnormal accruals observed on disclosure. However, if remediation does not occur within a year from disclosure, abnormal accruals continue to increase for virtually all MW types.
    • Information technology and segregation of duties problems share an element of personnel reallocation, as the definition of information technology issues shown in includes specific reference to segregation of duties. Remediating such problems could involve hiring new workers, changing assignments or workflows, and thus could take more time than the remediation of other MW types. However, earnings quality is shown to increase in those companies that invest in solutions to these problems and reassign personnel appropriately.
    Category:
    Internal Control
    Sub-category:
    Assessing Material Weaknesses, Assessing Remediation of Weaknesses, Impact of 404 on Fees and Financial Reporting Quality, Reporting Material Weaknesses
  • Jennifer M Mueller-Phillips
    Real Earnings Management before and after Reporting SOX 404...
    research summary posted March 22, 2016 by Jennifer M Mueller-Phillips, tagged 07.0 Internal Control, 07.05 Impact of 404 on Fees and Financial Reporting Quality, 14.0 Corporate Matters, 14.01 Earnings Management in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Real Earnings Management before and after Reporting SOX 404 Material Weaknesses.
    Practical Implications:

    The authors identify a setting where there is a greater risk of value reduction for stockholders. Specifically, they find that companies which have material weaknesses in internal controls are more likely to engage in real earnings management, through inventory management and reducing discretionary expenditures. While these activities are allowed by GAAP, the findings of this paper suggest management may take actions that are detrimental to firm value.

    Citation:

    Jarvinen, T. and E. Myllymaki. 2016. Read Earnings Management before and after Reporting SOX 404 Material Weaknesses. Accounting Horizons 30 (1): 119-141.

    Keywords:
    internal control, material weakness, real earnings management
    Purpose of the Study:

    This study investigates whether SOX Section 404 material weaknesses manifest in real earnings management behavior. The authors compare companies with effective internal controls to companies with existing material weaknesses, specifically looking at manipulation of real activities (particularly inventory overproduction). Such activity would suggest that companies strive to mitigate the expected negative reaction to disclosed material weaknesses by engagement in real earnings management.

    Design/Method/ Approach:

    The authors use company-year observations from public U.S. companies from 2004 to 2012. These company-years are split into three categories: 1) first year of internal control material weakness 2) years in which material weaknesses were disclosed as remediated 3) years in which material weaknesses were disclosed as nonremediated, and 4) company-years with effective internal controls. The authors observe differences in the extent of inventory management after controlling for various other predictors of real earnings management.

    Findings:

    The authors find:

    • Manipulation of real operational activities is associated with both the first-time existence of a material weakness and the subsequent disclosure of the material weakness.
    • Inventory overproduction is employed as an earnings management method before and after material weakness disclosure, and especially when the company has previously had poor financial performance.
    • Companies appear to cut discretionary expenditures when they have material weaknesses and when they have previously had poor financial performance.
    • Reduction in discretionary expenses is also used in the year when companies disclose and remediate material weaknesses.
    Category:
    Corporate Matters, Internal Control
    Sub-category:
    Earnings Management, Impact of 404 on Fees and Financial Reporting Quality
  • Jennifer M Mueller-Phillips
    Reflections on a Decade of SOX 404(b) Audit...
    research summary posted March 10, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 07.0 Internal Control, 07.05 Impact of 404 on Fees and Financial Reporting Quality in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Reflections on a Decade of SOX 404(b) Audit Production and Alternatives
    Practical Implications:

    Public interest demands more transparency and analysis about how control audits are conducted, how they might be improved, and what might be better alternatives for the future. Thus investors, auditors, standard setters, academics, auditing students and U.S. markets could all benefit in the long run, from more transparency about the current U.S. audit production process and from informed debate about the best mechanism design for balancing the needs of all parties interested in internal control quality disclosure.

    For more information on this study, please contact William R. Kinney Jr.

    Citation:

    Kinney Jr, W. R., R. D. Martin, and M. L. Shepardson. 2013. Reflections on a Decade of SOX 404 (b) Audit Production and Alternatives. Accounting Horizons 27(4): 799-813.

    Keywords:
    Sarbanes-Oxley Act of 2002; regulation alternatives; internal control audits; 404(b).
    Purpose of the Study:

    Since the passage Sarbanes-Oxley Act during July 2002, audit production in the U.S. has been substantially expanded by mandated internal control audits. The control audit mandate is unique to the U.S. and costly to apply, yet little is known about the conduct of control audits or the efficacy of lower-cost alternatives. Hence, this paper reflects the authors overall knowledge about control audit production and observation of a consistent message across public and limited non-public archival data. 

    Design/Method/ Approach:

    The authors have followed 404(b) audit implementation from perspectives as auditing educators, academic fellows at the Securities and Exchange Commission (SEC), advisor to the Public Company Accounting Oversight Board (PCAOB), standards setter as an International Auditing and Assurance Standards Board (IAASB) member, and a Big 4 audit manager applying 404(b).

    Other methods include: research projects; theoretical, archival, and behavioral research of others; and numerous control audit conversations regarding implementation with U.S. and foreign regulators, standards setters, practitioners, directors, corporate officers, and investors.

    Findings:

    Main observations

    • Audits of internal control processes are fundamentally different from audits of financial statements as to objective, value, and approach, although they share some attributes.
    • The three sources of control audit evidence required by PCAOB standards differ substantially in incremental costs, audit expertise required, and ability to identify material weaknesses so that:
      • Relative to design evaluation and implementation testing, auditors are effective and efficient at identifying control weaknesses that have resulted in known accounting misstatements—even if the misstatements are immaterial.
      • Absent knowledge of accounting misstatements, identification of weaknesses in control process design is difficult.
      • The appropriate scope of operating effectiveness testing remains unclear, as does when entity-level control tests can substitute for process-level control tests.

    Alternatives to mandated control audits:

    • No other country or auditing standards-setting body has adopted the U.S. control audit legislated mandate, even though it has been considered in multiple countries.
    • Some other countries have developed alternatives that partially apply the U.S. requirements and provide some control information to investors, but at less cost of production.
    Category:
    Internal Control, Standard Setting
    Sub-category:
    Impact of 404 on Fees and Financial Reporting Quality, Impact of SOX
  • Jennifer M Mueller-Phillips
    The effect of Auditing Standard No. 5 on audit fees
    research summary posted March 11, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.02 Changes in Audit Standards, 07.0 Internal Control, 07.05 Impact of 404 on Fees and Financial Reporting Quality in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    The effect of Auditing Standard No. 5 on audit fees
    Practical Implications:

    The results provide support for regulators’ expectations about AS5’s overall fee-saving (but not their expectations of greater savings for smaller, less complex companies). The authors conclude that overall, there was a reduction in audit fee under the AS5 standard, but mainly for complex firms.

    For more information on this study, please contact Jagan Krishnan.

    Citation:

    Krishnan, J., J. Krishnan, and H. Song. 2011. The effect of Auditing Standard No. 5 on audit fees. Auditing: A Journal of Practice & Theory 30(4): 1-27.

    Keywords:
    audit fee; AS5; audit quality; PCAOB; SOX 404.
    Purpose of the Study:

    In light of the controversy over implementation cost surrounding Auditing Standard No. 2 (AS2), the PCAOB responded by superseding AS2 with Auditing Standard No. 5 (AS5), An Audit of Internal Control Over Financial Reporting That Is Integrated with an Audit of Financial Statements, effective for fiscal years ending November 15, 2007.  This paper examines the effect of the change from AS2 to AS5 on audit fees. The paper seeks to answer the following questions:

    • Were audit fees lower in the first two years of adoption of AS5 (other things being equal) compared to AS2?
    • More specifically, did AS5 have an impact on audit fees for firms with material weaknesses in internal control?
    • Was there was a difference in fee changes across client size/complexity groups?
    Design/Method/ Approach:

    The study’s primary tests are based on a comparison of audit fees in 2006 (the last year of AS2 audits) with audit fees in 2007–2008 (the first two years of AS5 audits) for a sample of ‘‘stable’’ auditor-client relationships.  Thus, the sample period was 2006-2008. The authors employ a longitudinal sample of firms (the ‘‘full sample’’) that had the same auditor over the four-year period 2005–2008, thus including a year prior to the sample period. Additionally, the study examines the fee trends for a ‘‘clean sample’’ consisting of firms that had clean ICFR opinions throughout our sample period.            

    Findings:

    Overall, the authors find AS5 had a statistically negative effect on audit fees.

    • After controlling for previously identified covariates of audit fees, the authors find audit fees were lower in the first two years of AS5 implementation as compared with the last year of AS2 (4.11 percent and 3.92 percent, based on the median firm, for the full and clean samples, respectively)
    • Consistent with previous work, this study finds that firms with adverse opinions on internal control pay higher fees than those with clean opinions. However, the premium paid by client with adverse opinions is smaller under AS5 than under AS2, which is consistent with a reduction in over auditing or over-conservatism in reporting material weaknesses.
    • Contrary to the expectation that less complex firms would benefit from AS5, this study reports a reduction in audit fee under the AS5 standard mainly for complex firms.
    Category:
    Internal Control, Standard Setting
    Sub-category:
    Changes in Audit Standards, Impact of 404 on Fees and Financial Reporting Quality
  • Jennifer M Mueller-Phillips
    The Effectiveness of SOX Regulation: An Interview Study of...
    research summary posted April 15, 2014 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.05 Impact of SOX, 07.0 Internal Control, 07.05 Impact of 404 on Fees and Financial Reporting Quality, 14.0 Corporate Matters, 14.11 Audit Committee Effectiveness in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    The Effectiveness of SOX Regulation: An Interview Study of Corporate Directors
    Practical Implications:

    A large majority of the directors interviewed for the purpose of this study maintained that, costs aside, SOX had positively impacted the quality of financial reporting. This can be supported by the decline in major frauds since the passage of the Act. On the downside, several directors also noted that SOX had negatively impacted corporate risk taking. Overall, corporate directors were by and large supportive of the SOX regulation. This conclusion runs counter to the typical opposition that corporate America has to any additional regulation.

    For more information on this study, please contact Jeffrey R. Cohen.
     

    Citation:

    Cohen, J. R., C. Hayes, G. Krishnamoorthy, G. S. Monroe, and A. M. Wright. 2013. The Effectiveness of SOX Regulation: An Interview Study of Corporate Directors. Behavioral Research in Accounting 25 (1).

    Keywords:
    audit process; corporate governance; qualitative research; risk management; Sarbanes-Oxley Act.
    Purpose of the Study:

    The Sarbanes-Oxley Act (SOX) was enacted in July 2002 in response to a number of significant financial reporting failures. This legislation significantly expanded the authority and responsibilities of the audit committee and board in overseeing financial reporting and internal controls. This study was conducted to provide insights into the effectiveness of SOX regulation from the perspective of corporate directors. By examining these director’s experiences of the impact of SOX, the authors aimed to discover how public corporations have responded to the legislation. Specifically, this study attempts to analyze the effectiveness of SOX with respect to achieving high-quality financial reporting.

    Design/Method/ Approach:

    The authors interviewed 22 experienced public company directors in 4 cities: Boston, Los Angeles, Chicago, and New York. The directors were chosen with a view to capture a cross-section of corporate governance experience, industries, and company size. The interviews were conducted over a 5 week period in 2007 just before the financial crisis of late 2007. The interviews varied in length from 30 to 60 minutes. All interviews were conducted by a single person in the offices of the participants, with the exception of one interview that was conducted by telephone. The interviews were guided by a pre-determined set of interview questions based on Cohen et al (2010), with additional questions added regarding SOX provisions and other SOX-related academic literature.

    Findings:
    • Directors have experienced enhanced expertise, attitude, process, and power and authority of the audit committee.
    • Post-SOX internal scope, level of responsibility, and status of internal audit functions have seen substantial improvement.
    • Compliance with SOX has led to greater empowerment of the audit committee.
    • CEO/CFO certification has increased CEO ownership of the integrity of financial disclosure and has been pushed down through the organization.
    • Management is still actively involved in the decision management process, including such matters as the appointment of the auditor.  
       
    Category:
    Corporate Matters, Internal Control, Standard Setting
    Sub-category:
    Audit Committee Effectiveness, Impact of 404 on Fees and Financial Reporting Quality, Impact of SOX
  • Jennifer M Mueller-Phillips
    The Impact of PCAOB Auditing Standard No. 5 on Audit Fees...
    research summary posted October 3, 2013 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.02 Changes in Audit Standards, 07.0 Internal Control, 07.05 Impact of 404 on Fees and Financial Reporting Quality in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    The Impact of PCAOB Auditing Standard No. 5 on Audit Fees and Audit Quality
    Practical Implications:

    This study provides an analysis of the effect of PCAOB Auditing Standard No. 5 (AS5) on internal control audit efficiency. The authors interpret their results as indicating that AS5 improved internal control audit efficiency by reducing audit fees without harming audit quality. The results of this study provide insight into the consequences of PCAOB standard setting, which is of interest to standard setters and businesses subject to their rules.


    For more information on this study, please contact Dechun Wang.
     

    Citation:

    Wang, D. and J. Zhou. 2012. The Impact of PCAOB Auditing Standard No. 5 on Audit Fees and Audit Quality. Accounting Horizons 26 (3): 493-511.

    Keywords:
    PCAOB Auditing Standard No. 5, audit fee, audit quality, internal control.
    Purpose of the Study:

    Due to strong complaints to the SEC and PCAOB about high audit costs associated with PCAOB Auditing Standard No. 2 (AS2) which governed internal controls audits, the PCAOB amended AS2 and proposed Auditing Standard No. 5 (AS5) in 2007. AS5 was aimed at reducing unnecessary costs and providing a more efficient audit of internal controls. It provides auditors a “top-down, risk-based” approach which allows them to tailor the audit to client size, complexity and specific critical risk areas. Furthermore, it provides auditors more flexibility in relying on the work of management and internal auditors.
        This study’s aim is to understand whether the PCAOB has accomplished its goal of making internal audits more efficient. The authors make a point to say that this requires not only audit fee reduction but also no drop in audit quality. The authors make and test the following hypotheses:

    H1: Audit fees are significantly lower after the adoption of AS5 for accelerated filers, but not non-accelerated filers (Note: AS5 does not apply to non-accelerated filers because the requirement of an audit of internal controls for these firms was initially deferred and eventually exempted by the Dodd-Frank Act of 2010)

    H2: Ceterus Paribus, audit quality does not change after the adoption of AS5
     

    Design/Method/ Approach:

    The authors utilize data on public companies around the 2007 implementation of AS5. They classify accelerated filers that had FYEs between November 15, 2007 (the AS5 implementation date) and November 14, 2008 as AS5 firms. They compare changes in audit fees for these firms to changes in audit fees in the previous year. They then compare changes in audit fees for AS5 firms to changes in audit fees for firms not subject to AS5 during the same period (non-accelerated filers). Finally they compare audit quality for AS5 firms in the year after AS5 implementation to the year immediately preceding AS5 implementation.

    Findings:
    • The authors provide evidence of a decrease in audit fees for the AS5 sample while audit fees increased for the pre-AS5 sample and the contemporaneous non-accelerated filing sample. 
    • The authors do not find a significant change in audit quality for the AS5 sample. This failure to find a significant result is robust to different measures of audit quality (Abnormal accruals, meeting or beating earnings forecasts and the probability of issuing an internal control weakness opinion).

    Taken together, the authors claim that these results are indicative of AS5 providing more efficient audits of internal controls. They argue that this result is confirmation that AS5 has accomplished the PCAOB’s objective of providing the same benefits of Sarbanes Oxley at a more reasonable cost to companies.

    Category:
    Internal Control, Standard Setting
    Sub-category:
    Changes in Audit Standards, Impact of 404 on Fees and Financial Reporting Quality
  • Jennifer M Mueller-Phillips
    The Interactive Effects of Internal Control Audits and...
    research summary posted July 28, 2015 by Jennifer M Mueller-Phillips, tagged 01.0 Standard Setting, 01.04 Impact of 404, 01.05 Impact of SOX, 07.0 Internal Control, 07.05 Impact of 404 on Fees and Financial Reporting Quality in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    The Interactive Effects of Internal Control Audits and Manager Legal Liability on Managers' Internal Controls Decisions, Investor Confidence, and Market Prices.
    Practical Implications:

    The results demonstrate a demand for IC audits such that, even in the presence of increased manager liability, the IC audit incrementally motivates managers to spend on improving IC and to provide more consistent and accurate ICFR disclosures. Unlike managers, investors react as though manager liability and IC audits are substitutes. This finding has implications for policymakers as it demonstrates the need to consider the possible differing effects of regulation on managers and investors. Moreover, with respect to regulatory actions to simultaneously implement both manager liability and an IC audit, the results suggest that both mechanisms may not be necessary to improve investors’ confidence and in turn market prices.

    Citation:

    Wu, Y., & Tuttle, B. 2014. The Interactive Effects of Internal Control Audits and Manager Legal Liability on Managers' Internal Controls Decisions, Investor Confidence, and Market Prices. Contemporary Accounting Research 31 (2): 444-468.

    Keywords:
    internal controls, internal auditing, investor confidence, Sarbanes-Oxley
    Purpose of the Study:

    This study investigates the effects of the audit of internal controls (IC audit) and manager liability for the company’s internal controls on investor confidence and market prices. This research is motivated by the substantial debate regarding the incremental effectiveness of IC audits and manager liability on investor confidence in financial disclosures. This debate came to the forefront with the Sarbanes-Oxley Act of 2002 (SOX) when the U.S. Congress simultaneously implemented both regulatory mechanisms. Section 302 requires that CEOs and CFOs personally attest, under penalty of perjury, that effective internal controls over financial reporting (ICFR) have been established, maintained, and evaluated on a timely basis. Section 404 requires that the auditors of publicly-traded companies provide assurance on the effectiveness of ICFR. However, direct empirical evidence remains limited regarding the individual versus joint effectiveness of these two regulatory mechanisms in (1) motivating managers to spend on improving ICFR and to provide more accurate ICFR disclosures and (2) improving investor confidence and market prices.

    Design/Method/ Approach:

    Seventy-six MBA students from a major public university participated in this study. The 76 participants resulted in a total of 19 sessions with four participants assigned to each. The experiment is programmed and conducted using ZTree software. Each session takes approximately 90 minutes and includes three practice rounds followed by 21 experimental rounds. The number of rounds is not known by participants. The evidence was collected prior to the summer of 2014.

    Findings:
    • Results suggest that the effects of manager liability and an IC audit are additive with respect to IC spending, with the IC audit having a stronger effect than manager liability.
    • Even after controlling for managers’ IC spending, results also demonstrate that IC audits improve the accuracy of managers’ ICFR disclosures.
    • Similar improvement is not associated with increased manager liability. In the presence of the IC audit, managers’ IC spending strategies are more constant over time and enable managers to provide accurate information more consistently regarding the effectiveness of ICFR.
    • Managers will spend more to improve ICFR when either liability or IC audits are present and that even in the presence of manager liability the IC audit incrementally increases managers IC spending.
    • The results demonstrate that investor confidence and stock price are no greater when both regulatory mechanisms are present than when only one is present.
    • Supplemental analyses suggest that manager reputation for accurate ICFR disclosures explains, at least in part, why investors perceive manager liability and IC audit to be substitutes.
    • The results suggest that when managers accrue a reputation for accurate ICFR disclosures, both regulatory mechanisms may not be necessary to improve investor confidence in managers’ earnings reports.
    Category:
    Internal Control, Standard Setting
    Sub-category:
    Impact of 404 on Fees and Financial Reporting Quality, Impact of 404, Impact of SOX
  • Jennifer M Mueller-Phillips
    The Persistence in the Association between Section 404...
    research summary posted March 10, 2015 by Jennifer M Mueller-Phillips, tagged 07.0 Internal Control, 07.05 Impact of 404 on Fees and Financial Reporting Quality in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    The Persistence in the Association between Section 404 Material Weaknesses and Financial Reporting Quality
    Practical Implications:

    This study asserts that, “overall, the findings of this study highlight the importance of discovering and disclosing material weaknesses in internal control over financial reporting.” Furthermore, in conclusion, this study states that:

    • In the post-MW404 period, there is a greater likelihood of existing control problems remaining unacknowledged and, therefore, casting doubts on whether the decision to report effective internal controls was actually the correct one.
    • Some entity-level MWs are more frequent in companies with undiscovered misstatements in the post-MW404 period compared to companies without undiscovered misstatements.
    • The additional exploration reveals that the majority of the misstatement incidences in the post-MW404 period are unrelated to the previously disclosed account-specific MWs.
    • It seems that the underlying driver of misstatements in the post-MW404 period is the unacknowledged pervasiveness of internal control problems. This study, hence, highlights the importance of discovering and disclosing material weaknesses.

    For more information on this study, please contact Emma-Riikka Myllymaki

    Citation:

    Emma-Riikka Myllymäki (2014) The Persistence in the Association between Section 404 Material Weaknesses and Financial Reporting Quality. AUDITING: A Journal of Practice & Theory: February 2014, Vol. 33, No. 1, pp. 93-116.

    Keywords:
    material weakness; misstatement; financial reporting quality; internal control remediation.
    Purpose of the Study:

    As is asserted in the study’s introduction, “This study investigates whether Section 404 material weakness (MW404s) disclosures are predictive of future financial reporting quality.

    • Whether or not the low financial reporting quality of MW404 companies persists into the post-MW404 period.
    • It is intuitive to assume that the low financial reporting quality of MW404 companies persists into the post-MW404 period.
    • Because MWs in internal controls carry a threat that material misstatements are not detected in a timely manner, the current study relies on the view that an incidence of a misstatement indicates a failure in a company’s internal controls
    Design/Method/ Approach:

    “The data used in this study consist of company-year observations of listed companies located in the U.S. covering the years 2005–2008… The data concerning the auditor’s attestation report on internal controls over financial reporting (Section 404), management’s disclosure controls reporting (Section 302), financial statement restatements, and auditor information are obtained from the Audit Analytics database. The financial statement data are obtained from the Thomson Financial database, and the audit committee variables from the Corporate Governance Quotient data.”

    The study draws its conclusions by dividing the data into companies with qualified internal control audit opinions and companies with unqualified internal control audit opinions. 

    Findings:

    The study’s conclusion asserts, “The empirical findings indicate that companies in the post-MW404 period are more likely to have undiscovered misstatements in their financial statements than companies that never had MW404s. Specifically, the effect is estimated to persist for two fiscal years, over which time the magnitude of the effect decreases non-linearly with decreasing speed. The finding of persistence is further supported by a number of sensitivity tests (propensity score matching, among others) and the quarterly investigation of misstatements and 302 weakness disclosures.”

    Category:
    Internal Control
    Sub-category:
    Impact of 404 on Fees and Financial Reporting Quality
  • Jennifer M Mueller-Phillips
    Was Dodd-Frank Justified in Exempting Small Firms from...
    research summary posted November 26, 2014 by Jennifer M Mueller-Phillips, tagged 04.0 Independence and Ethics, 04.08 Impact of SEC Rules Changes/SarbOx, 06.0 Risk and Risk Management, Including Fraud Risk, 06.06 Earnings Management, 07.0 Internal Control, 07.05 Impact of 404 on Fees and Financial Reporting Quality, 08.0 Auditing Procedures – Nature, Timing and Extent, 08.05 Evaluating Accruals/Detection of Abnormal Accruals, 08.06 Earnings Management – Detection and Response, 14.0 Corporate Matters, 14.01 Earnings Management in Auditing Section Research Summary Database > Auditing Section Research Summaries Space public
    Title:
    Was Dodd-Frank Justified in Exempting Small Firms from Section 404b Compliance?
    Practical Implications:

    Our study evaluates a provision of Dodd-Frank which provided permanent exemption from Section 404b compliance to non-accelerated filers. Our results show that these small firms did not improve their reporting quality to the same extent as large firms implying that the Dodd-Frank exemption will probably serve to keep the reporting quality of the exempted firms at lower than achievable levels.

    We also note that as part of the Dodd-Frank legislation, the SEC was given a mandate to investigate raising the Section 404b exemption requirements from $75 million to $250 million in market capitalization (Dodd Frank 2010). While the SEC eventually decided to leave the exemption criterion at $75 million, this matter is still considered to be an open topic (SEC 2011). Our study informs this ongoing debate.

    For more information on this study, please contact

    Anthony D. Holder, PhD, CPA

    Assistant Professor, Department of Accounting - MS 103

    University of Toledo

    Toledo, OH 43606-3390

    Email: Anthony.Holder@utoledo.edu

    Web:    http://homepages.utoledo.edu/aholder4/

    Phone: 1.419.530.2560

    Fax: 1.419.530.2873 

    Citation:

    Holder, A., K. Karim, and A. Robin. 2013. Was Dodd-Frank Justified in Exempting Small Firms from Section 404b Compliance? Accounting Horizons 27 (1): 1-22.

    Keywords:
    Sarbanes-Oxley; Dodd-Frank; earnings management; exempt filers
    Purpose of the Study:

    A major component of the Sarbanes-Oxley Act of 2002 (SOX) is Section 404b, which requires auditor certification of internal controls. However, not all firms were required to comply with this section. Fearing that compliance costs may be prohibitive, SOX allowed a temporary exemption to small firms called non-accelerated filers (typically those firms with market capitalizations under $75 million). Later, the Dodd-Frank Act of 2010 made this exemption permanent.

    Needless to say, both 404b itself and the small-firm exemption, remain controversial. At the heart of the issue, as with any regulation, is the cost-benefit tradeoff. In this particular instance, what are the potential benefits small firms would have obtained had they been subject to SOX Section 404b? By focusing just on the costs of compliance, we may be overlooking these benefits. We consider these foregone benefits an opportunity cost.

    The purpose of our study is to estimate this opportunity cost. We estimate the benefits lost by small firms, because they were not subject to SOX Section 404b.

    Design/Method/ Approach:

    Our sample contains listed firms (subject to SOX), divided into the large (accelerated) and small (non-accelerated) categories. Our data span the SOX period and are from 1995-2009. We measure reporting gains using two standard approaches, one measuring the extent of earnings management and the other measuring accrual quality.

    The reporting benefits foregone by small-firms can be understood by comparing the following two quantities:

    • Post-SOX reporting gains achieved by large firms (accelerated filers).
    • Post-SOX reporting gains achieved by small firms (non-accelerated filers). If these gains (or losses) are smaller than those achieved by large firms, we know there is an opportunity cost.
    Findings:

    We detect a significant deterioration in reporting quality for non-accelerated filers but not for accelerated filers. The result is invariant to whether we compare non-accelerated filers with all accelerated filers or only with small accelerated filers.  Our findings suggest a significant opportunity cost for the exemption. Although the consideration of the cost of Section 404b compliance is outside the scope of our study, our result concerning the opportunity cost suggests that it may have been premature to grant permanent exemption to the non-accelerated filers. This result is especially important, considering contemporaneous discussions to grant Section 404b exemption to even larger firms (up to a market capitalization of $500 million).

    Category:
    Auditing Procedures - Nature - Timing and Extent, Corporate Matters, Independence & Ethics, Internal Control, Risk & Risk Management - Including Fraud Risk
    Sub-category:
    Earnings Management – Detection and Response, Earnings Management, Evaluating Accruals/Detection of Abnormal Accruals, Impact of 404 on Fees and Financial Reporting Quality, Impact of SEC Rules Changes/SarBox